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Cutting Capital Gains Taxes: History Says It's A Mistake

August 23, 1992

Economic Trends

CUTTING CAPITAL-GAINS TAXES: HISTORY SAYS IT'S A MISTAKE

If there's one subject on which conservatives, Republicans, the investment community, and most businesspeople seem to agree, it's the beneficial impact that a capital-gains tax cut would have on the economy. Such a tax cut, they claim, would promote more savings and investment and thus foster long-term growth.

Opponents of preferential treatment of capital gains, on the other hand, argue that it would mainly confer huge tax relief to the top 1% of taxpayers who account for the overwhelming bulk of such gains. Its purported benefits, they say, are at best wildly exaggerated.

Under present law, over half of all capital gains are currently untaxed anyhow, either because they accrue to tax-exempt pension funds, or to foreign owners not subject to U.S. taxes, or because assets held until death escape such taxation. Taxpayers are also able to defer taxes on unrealized capital gains until years when their overall tax liability is low. The upshot, note tax-cut opponents, is that the effective tax rate on capital gains is already under 10%.

Such details are unlikely to temper the zeal of tax-cut advocates. But in an article in the current issue of Contemporary Policy Issues, Joseph J. Minarik, chief economist of the House Budget Committee, points out that economists studying capital-gains taxation "have the benefit of a series of uncontrolled experiments in the real world: multiple changes in tax treatment of capital gains over the past two decades."

Since 1975, capital-gains taxes have been raised twice (in 1976 and 1987) and lowered three times (in 1978, 1981, and 1984). And as the chart shows, the behavior of U.S. savings and investment in the wake of these changes was exactly the opposite of that predicted by tax-cut advocates. National saving as a percent of gross domestic product (which includes government, business, and household savings) fell sharply in the years following each of the three capital-gains tax cuts. And it rose significantly on the heels of each of the tax hikes.

To be sure, national saving in the 1980s was obviously far more affected by the soaring federal deficit than by shifts in capital-gains taxation. But saving by households exhibits the same basic pattern. Notes Minarik: "In the early 1980s, taxpayers received two capital-gains tax cuts, a dazzling array of other tax incentives for saving, and record-high real-interest rates, but the personal-saving rate fell like a stone." In contrast, since the repeal of the capital-gains exclusion, the personal-saving rate has stabilized and trended higher.

As for investment, commercial real estate did soar after the 1980s capital-gains tax cuts went into effect. But investment in equipment, the heart of productive business investment, traced the same perverse trends as overall savings did--rising after capital-gains tax hikes and falling after tax cuts (chart).

Given the complex factors influencing economic behavior in the real world, none of this proves definitively that a capital-gains tax cut would not stimulate some savings and investment. But Minarik maintains that recent history does suggest that such positive effects would be minimal. "The burden of proof," he says, "rests with those who would reduce the taxes of the wealthy for benefits that appear dubious."GENE KORETZ